Will a new securities exchange be effective to promote long-term value creation?

Many have recently lamented the decline in the number of IPOs and public companies generally (from about 8,000 in 1996 to about 4,000 now, according to EY), and numerous reasons have been offered in explanation, from regulatory burden to hedge-fund activism. (See this PubCo post and this PubCo post.) In response, some companies are exploring different approaches to going public, leading to a recent resurgence in SPACs (see, e.g., this WSJ article), while others are flirting with the possibility of “direct listings,” which avoid the underwritten IPO process altogether (see, e.g., this article discussing the pending NYSE rule change to facilitate direct listings). At the same time, companies are seeking ways to address some of the perceived afflictions associated with being public companies—including the pressures of short-termism, the risks of activist attacks and potential loss of control of companies’ fundamental mission—through dual-class structures and other approaches. Changing dynamics are not, however, limited to companies. And one of the most interesting proposals designed to address these issues is being introduced on completely different turf—a novel concept for a stock exchange, the Long-Term Stock Exchange. According to the LTSE blog, “[w]hile other proposed solutions target the IPO process, the LTSE’s mission is to transform the public company experience by relieving the short-term pressures that plague today’s businesses and laying the foundation for a healthier public market ecosystem.”

Many have recently lamented the decline in the number of IPOs and public companies generally (from about 8,000 in 1996 to about 4,000 now, according to EY), and numerous reasons have been offered in explanation, from regulatory burden to hedge-fund activism. (See this PubCo post and this PubCo post.) In response, some companies are exploring different approaches to going public, leading to a recent resurgence in SPACs (see, e.g., this WSJ article), while others are flirting with the possibility of “direct listings,” which avoid the underwritten IPO process altogether (see, e.g., this article discussing the pending NYSE rule change to facilitate direct listings). At the same time, companies are seeking ways to address some of the perceived afflictions associated with being public companies—including the pressures of short-termism, the risks of activist attacks and potential loss of control of companies’ fundamental mission—through dual-class structures and other approaches. Changing dynamics are not, however, limited to companies. And one of the most interesting proposals designed to address these issues is being introduced on completely different turf—a novel concept for a stock exchange, the Long-Term Stock Exchange. According to the LTSE blog, “[w]hile other proposed solutions target the IPO process, the LTSE’s mission is to transform the public company experience by relieving the short-term pressures that plague today’s businesses and laying the foundation for a healthier public market ecosystem.”

What started as a more of a pipedream—and one designed to entice someone else to take up the challenge—is apparently now a project in discussions with the SEC and backed by some heavy-hitting investors. The concept is to offer, through listing standards and other tools, a “new approach to governance designed for the mutual benefit of companies and investors.” In particular, the exchange’s founder and CEO discovered in his conversations with entrepreneurs that many were reluctant to go public. Why? Always for the same reasons: “managers are concerned. Concerned about losing control of their company. Concerned about having to manage to the quarter. Concerned about compromising the company mission. Concerned about the distractions that take energy away from serving customers and creating value. Concerned about being punished by the markets for investing in anything other than driving short-term metrics.” What was needed, he decided, was “a new public securities exchange designed to promote long-term value creation.” The new exchange would “craft a new bargain between great companies and long-term-oriented investors that share the collective goal of innovation and value creation.”

SideBar

Much has been written about the corrosive effects of short-term thinking in corporate America. As noted in a post from The Harvard Law School Forum on Corporate Governance and Financial Regulation, a recent academic study revealed that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.” (See this PubCo post and this article in The Atlantic.) Apparently, they weren’t kidding. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks (which can drive increases in EPS), leaving little for alternative uses of capital, such as long-term strategic investment in productive assets, including investment in R&D. (See this PubCo post.) As observed by Professor John Coffee in this post, “[p]resumably, it is self-evident that if an economy cuts back drastically on its investment in ‘R&D,’ it will experience less innovation and technological advances in the future…. That should be a cause for concern.” (See this PubCo post.)

Why has short-termism taken hold? There are many points of view on the reasons, with blame attributed to, among other things, executive compensation (see this PubCo post and this PubCo post), pressure from Wall Street to increase quarterly EPS (see this PubCo post), traders’ compensation (see TheAtlantic article), the “legal underpinnings” of capital markets regulation and the business model and prevailing culture of the investment management industry (see this PubCo post), caselaw regarding directors’ fiduciary duties (see this PubCo post), and, perhaps most significant, hedge fund activism. As suggested in this NYT DealBook column, the activist playbook is certainly not limited to buybacks and dividends: “[a]s activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.”

Fortunately, some of the largest asset managers and institutional holders, such as BlackRock, have increasingly focused on long-term value creation. (See, e.g., this PubCo post.) And this study from consulting firm McKinsey suggests that some of the pressures to emphasize short-term financial performance could be mitigated by building alliances with sophisticated long-term investors. (See this PubCo post.)

According to reporting in Bloomberg, the NYT and Quartz, in addition to standard listing requirements, the new bargain adds three key tenets:

Additional disclosure policies, such as a moratorium on “guidance,” and disclosure requirements that allow investors to know what investments the company is making, such as more detail on R&D spending.

Tenure voting, meaning that long-term holders (which the exchange’s founder refers to as “citizens of the republic,” according to the NYT) have incrementally more voting power than short-term holders (termed “tourists”), so long as the investor discloses the real name of the beneficial owner.

SideBar

Tenure voting, discussed in this PubCo post from 2015, is a technique resurrected from the 1980s that some believe could be used to repel hedge-fund activists and other short-termers. The concept would give investors additional votes if they hold their shares for at least a specified period of time, thus rewarding long-term holders by giving them more say in the future of the company than, say, short-term hedge fund activists that may favor short-term profits over long-term business strategies. The concept was reportedly invented during the 1980s in response to a wave of hostile takeover attempts. Perhaps the first company to implement this approach was J.M. Smucker Co., which adopted a tenure voting plan as a shareholder protection measure. Under the plan, existing shareholders received ten votes for each share held. However, upon transfer, these shares would revert to one vote per share, but would regain super-voting status if they were held for 48 consecutive months. In 1996, in Williams v. Geier, the Delaware Supreme Court upheld adoption by the board of a similar plan as a proper exercise of the business judgment rule to promote long-term planning (even though the effect of the plan was to concentrate voting rights in hands of a controlling block); the plan was then approved by a fully informed shareholder vote, which was considered dispositive.

Selection from “a menu of LTSE-approved compensation plans designed to make sure executive pay is not tied to short-term stock performance,” with vesting required for at least five years and recommended for as long as 10 years, even after the executive may have left the company. Reportedly, these plans would avoid bonuses tied to metrics such as EPS, which, the exchange’s founder believes, “pushes [executives] to goose the numbers.”

SideBar

In this article, posted on CFO.com, two consultants argue that the use of the three-year time horizon frequently associated with performance-based restricted stock grants may not really be long enough, especially where the performance measure is relative total shareholder return (TSR). In fact, they contend, perhaps with a touch of hyperbole, it has the “potential to be dangerous” because the “payouts to executives may reward short- to mid-term stock price volatility rather than sustained long-term TSR performance.” They argue that, although a 10-year performance period would “more closely corresponds to the life cycle of business strategies,” that duration may be impractical and suggest instead that comp committees “think about a performance period of five years or even four years, which may provide a better balance between executives’ reluctance to wait to receive compensation and shareholders’ concerns that equity awards should reward long-term value creation. Additionally, if there are tenure concerns with five years, it is possible to structure a five-year performance period on an award that only requires three years of continuous service.” See this PubCo post.

Apparently, the LTSE is currently in discussions with the SEC for approval to become a new national securities exchange. That will certainly not happen overnight. Bloomberg reports that, if the new exchange is approved, the exchange’s founder “will face what may turn out to be his biggest challenge: persuading a company to be first to list on LTSE.” But, interestingly, he isn’t courting the current crop of unicorns. Rather, “he’s connecting with mid-size startup founders [and] hopes a handful of these companies will emerge as strong IPO candidates. If he’s lucky, one will be confident enough to be a pioneer.” According to Quartz, “[o]ne potential obstacle to starting a new stock exchange is the challenge of getting the first companies to list on it, given uncertainty about whether there will be adequate investor activity to provide liquidity and fair prices. To solve this, the LTSE aims to allow companies to have dual listings, with their shares also trading on any other US regulated market, such as the NYSE or Nasdaq.” But will competitive exchanges such as the NYSE or Nasdaq help the LTSE along by permitting interpretations of their voting rights policies to permit listings of companies with tenure voting? Although there certainly are valid arguments suggesting that tenure voting is, or should be, permitted, it’s hardly a slam-dunk.

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